New Economic Nationalism

Globalization reached its zenith in the late twentieth and early twenty-first centuries. This rise of
international trade and free movement of capital facilitated a period of unprecedented growth and
prosperity.

But as English statesman Lord Palmerston noted: “nations have no permanent friends or allies, they only
have permanent interests.” In the aftermath of the global financial crisis, these interests dictate a reversal
of the trend toward greater global integration and a return to autarky.
“Juche” World

In economics, autarky refers to a closed economy with limited international trade or capital flows.
The Austro-Hungarian Empire, Japan during the Edo period, Nazi Germany and Italy under Benito
Mussolini all pursued national policies favoring autarky. More recently, countries as varied as the Soviet
Union, Afghanistan (under the Taliban), Cambodia (under the Khmer Rouge) and Myanmar, until recently,
operated as closed economies. Today, the world is implicitly embracing Juche, North Korea’s autarky-
focused state ideology.

Unprecedented economic and financial pressures are behind this shift toward closed economies. This
coming economic war may reshape the world order in unexpected ways.

Crumbling Walls
The post-Second World War period saw remarkable expansion in global trade and capital flows. The
collapse of the Berlin Wall and re-integration of China, Russia and Eastern European into the world
economy provided impetus for globalization.

Consumption and production were unbundled, expanding over time into the division of manufacture
itself. As each stage of production was undertaken in the most efficient location, businesses and nations
rapidly embraced a transnational system of production.

Deregulation allowed globalization of capital. Savings in one part of the world sought attractive and
profitable investment opportunities in another. Investment and risk management instruments facilitated
this Monetary Diaspora.

Globalization was a product of its times. In a virtuous cycle, it both created and relied on strong economic
growth. Individual nations sacrificed national interest as benefits of integration outweighed costs.

Prosperity discouraged inquiry into the drivers and assumptions behind the drive toward global
integration, burying its essential fragility.

Less Gain, More Pain

Enlightened self-interest underpinned the system, as long as it delivered prosperity for most nations. For
many nations, following the global financial crisis, the advantages of greater economic and monetary
integration are now less obvious. A self-reinforcing combination of economic, political and social factors
is now driving a shift towards closed economies.

Economic growth overall has slowed and is likely to be tepid for an extended period. For many nations,
the reduced direct benefits of global trade and capital dictate a withdrawal to more closed economies. By
closing their economies and focusing domestically, nations believe that they can capture a greater share
of available growth and deliver greater prosperity for their citizens.

The forecast distribution of future growth also influences this shift. Less affected by the crisis, for
emerging nations, the benefits of participation in the global economic system, which previously assisted
improvements in their living standards, are now diminished. Less affected by the crisis, they are wary of
having to pay for the problems of many developed countries.

The crisis also highlighted the composition of income and wealth which underlay globalization.
In manufacturing, profits in the value chain require control of essential intellectual property rather than
production. The majority of profits from Apple’s iPhones, made in and recorded as part of China’s
exports, comes from high-tech components, intellectual property and branding which are captured by
non-Chinese firms.

Developed nations and businesses control vital logistics and supply chains for vital trade. They dominate
international financial activities, generating substantial earnings from financing trade and managing
investments.

When growth rates were high, the unbalanced distribution of benefits of globalization was tolerated,
albeit grudgingly. But lower growth rates and decreased benefits may lead nations to seek to maximise
their own position at the expense of others, reducing the degree of engagement in a global economic
system.

Links in the Chain

In an economically integrated world, supply chains for goods and vital commodities are international
rather than national. This makes them sensitive to changes in cost structures, currency values and
transportation costs.

International supply chains are also vulnerable to disruption from climatic or environmental factors. The
Japanese tsunami and Thai floods of 2011 highlighted the vulnerability of supply chains, when shortages
of minor but essential components halted production elsewhere. These disasters also highlighted the
threat to secure access to essential resources such as oil, water and food.

There is now increased recognition that specialization leaves national and regional economies vulnerable
to competitive pressure from other nations or localities or dislocations in supply chains. These factors
may also drive a reversal of globalization and a shift to more closed economies.
Plugging Leaks

Economic and political sovereignty is undermined by globalization. The financial crisis revealed that
integration reduces the effectiveness of a nation’s economic policies, unless other nations take co-
ordinated action.

Governments reacted to the global financial crisis by initiating large government spending programs to
support the economy. In many cases, there was significant financial leakage, with spending boosting
imports rather than promoting domestic demand, employment, income and investment.
Changes in tax policy can be rendered ineffective if other countries do not follow suit.

The problems are greater for global issues requiring internationally co-ordinated policies, such as climate
change and better management of scarce non-renewable resources. Emerging nations are unwilling to
accept initiatives that would impinge on their growth and policy flexibility. They argue that the problems
are the result of past poor practices and resource management by developed nations for which they
should not have to pay the price.

This also implicitly encourages pursuance of strategies that favour national objectives at the expense of
other countries. International agreements on global issues which require self-sacrifice on the part of
nations become difficult.

Autarky or closed economies is a natural way to deal with these pressures, reasserting sovereign control.
As one nation adopts such policies, it compels other countries to pursue similar strategies to protect its
own interests.

Trade Diseases
Various breakdowns—restrictions on trade, currency manipulation, capital controls and predatory
regulations—now signal the retrenchment of globalization and return to autarky.

Despite oft-repeated statements at G-20 meetings about the importance of free trade and avoiding the
mistakes of the 1930s, trade restrictions are increasing. The motivation is protection of national
industries, iconic businesses, employment, incomes and competitive advantage.

Subsidies, government procurement policies favouring national suppliers, “buy local” campaigns,
preferential financing and industry assistance policies are used to direct demand. Safety and
environmental standards are used to prevent foreign products penetrating national markets.

Direct intervention, artificially low interest rates and quantitative easing are deliberate policies to
manipulate currencies. Devaluation makes exports more competitive assisting individual countries to
capture a greater share of global trade, boosting growth. Devaluation is also used to reduce real debt
levels by reducing the purchasing power of foreign investors holding a nation’s debt.
But such actions invite destructive retaliation in the form of tit-for-tat currency wars. In February 2013,
Chile’s Finance Minister writing in the Financial Times warned that “by seeking relief at the expense of
other economies, [quantitative easing] is, in its essence, a globally counterproductive policy”. The process
is also ultimately self-defeating as not every country can have the cheapest currency.

Monetary Borders

Free movement of capital has become increasingly restricted. Since 2008, the growth in cross border
capital flows have slowed with global financial assets increasing by just 1.9% annually, well below the
7.9% average growth from 1990 to 2007.

Governments have resorted to financial repression, a process designed to channel funds to governments
to help liquidate otherwise unsustainable debts or prop up financial institutions and economic activity.

Nations with high levels of government debt that face financing difficulties seek to limit capital outflows.
These would prevent depositors and investors withdrawing funds to avoid potential losses from
sovereign defaults or in Europe a breakdown in the common currency and redenomination of
investments into a domestic currency. In Cyprus, explicit capital controls designed to prevent capital
flight were implemented.

Low interest rates and weak currencies in developed economies have led capital to flow into emerging
nations, with higher rates and stronger growth prospects. Volatile, short term capital inflows threaten to
destabilise economies, by driving up the value of currencies and creating inflationary pressures. Brazil,
South Korea and Switzerland have implemented controls on capital inflows.

Currency volatility also affects economic development in other ways. Devaluation of the US dollar drives
up the price of commodities, such as food and energy which are denominated in the American currency.
In poorer countries where spending on food and energy, including everyday essentials like cooking oil, is
a high proportion of income, this causes hardship.

Higher commodity prices in combination with large flows of capital create inflationary pressures in many
countries which force authorities to increase interest rates that slow economic growth. These
developments threaten to reverse progress in reducing poverty.

These pressures have meant that the movement of capital has become increasingly restricted. In a
significant reversal of its historical policy, the IMF has accepted the use of “targeted, transparent, and
generally temporary” direct controls to limit volatile cross-border capital flows.

Thieves Falling Out

Nations are increasingly using regulatory initiatives to gain advantage.

In the aftermath of the financial crisis, developed nations worked together to strengthen regulation of
financial institutions. The proposals are intended to be adopted internationally, ensuring consistency and
a level playing field.

Stringent regulations of multinational financial institutions, active in complex financial products, may not
be appropriate for countries with less developed financial systems. Under the guise of regulations
needed to strengthen the financial system, the US has implemented measures whose extra-territorial
application may give American banks a business advantage.

Emerging nations especially argue that adoption of these proposals would impede the ability of local
banks to provide credit necessary to support local economies. It would also pose significant compliance
costs and erode their competitive position. They are increasingly sceptical about accepting such
regulatory standards.

These differences may lead to the lack of uniform financial regulation, resulting in a balkanised global
financial system.

In 2013, the European Union proposed a financial transactions tax which would be collected by the Euro-
Zone’s biggest economies but would be applicable to trades in all the world’s main financial centres. The
objective was to raise revenue, with the secondary objective of reining in speculative trading. But it was
the extra-territorial reach of the proposal that was interesting.

The proposal revealed divisions within Europe. The UK opposed to the tax as it would affect its
economically important financial services centre in London. The US also opposed the tax, expressing
determination to ensure that even if implemented it did not extend outside the Euro-Zone or affect
legitimate activity outside of their borders. The UK and the US sought to protect their large and globally
important financial services firms, just as the European proposal sought, indirectly, to reduce their
influence.

All of these steps impede free movement of capital, one of the hallmarks of globalization.

Drift Toward Closed Economies

Evidence of the end of globalization and greater integration is mounting. Growth in trade and cross-
border investment which has underpinned prosperity and development is being reversed.

Despite the economic benefits of global trade, a retreat to autarky and policies that favor closed
economies is now a serious possibility with far-reaching consequences.

If current economic pressure lead to a shift to autarky, then the US, Europe and China are likely to find
closed economies a realistic policy option, although for different reasons.
Splendid Isolation

Structurally, the US can function successfully as a closed economy.

The US remains the world’s largest economy, around 25% of global Gross Domestic Product (“GDP”) and
almost twice the size of China, the second largest economy.

America’s economy has access to a large domestic market. It is less exposed to trade (around 15% of
GDP) than other large economies.

Despite inequality in the distribution of income, America remains relatively wealthy, with per capita GDP
of around US$50,000. American households have substantial net worth in excess of US$70 trillion,
although down from a peak of over US$80 trillion before the financial crisis.

The US remains a major food producer with agriculture being a major industry. It is a net exporter of
food, controlling almost half of world grain exports.

It is also rich in mineral resources. New technology has enabled America to access oil and natural gas,
especially shale gas, from previously geological formations that were previously inaccessible. While US
energy independence is not likely in the near term, increase in domestic energy production provides
America with a significant advantage through competitive energy costs. Reduction in energy imports also
reduces its reliance on foreign suppliers.

The US dollar remains the world’s reserve currency, with a market share of around 60% of global
investments. The majority of global trade continues to be denominated in US dollars. The US borrows in
its own currency, benefitting from a ready market for its securities, both domestically and internationally.

The US has favourable demographics. It has high population growth relative to other industrialized
countries, which have below-replacement fertility rates. The US has higher levels of immigration,
remaining a magnet for immigration attracting talent and additional labour.

Retreat from global integration is integral to the US dealing with its economic issues.

Key policies include maintaining low interest rates to reduce the cost of servicing debt allowing higher
levels of borrowings to be sustained in the short run. Low rates and quantitative easing measures help
devalue the US dollar, reducing the level of government debt, by decreasing its value in foreign currency
terms.

A weaker US dollar boosts exports, reducing trade imbalances. A weaker dollar also reduces the cost base
of domestic production encouraging a shift of production, manufacturing and assembly work back into
the US. This should assist in creating the jobs needed to reduce unemployment.

Stronger growth and lower unemployment will assist in reducing the large US budget deficit.
A shift to a more closed economy is consistent with America’s natural isolationism, focused on
aggressively protecting the nation’s economic self-interest and expanding US power and influence. As
William G. Hyland, Deputy National Security Advisor to US President Gerald Ford and editor of Foreign
Affairs magazine, noted: “protectionism is the ally of isolationism”.

European Desperation

Escalating sovereign debt and banking sector problems favour European introspection.

Individual European economies are modest in size relative to the US. But as a combined entity the
European Union (“EU”), including the 17 member Euro-Zone who share a common currency, constitute
over 25% of global GDP, making it the world’s largest economic unit.

The EU is a more open economy, being the world’s largest exporter and importer of good and services.
But around 75% of its trade is within member nations, aided by removal of trade barriers and the
common currency. For example, Germany, the EU’s largest economy and one of the world’s largest
exporters, sells over 60% of its products within the common market, much of it to other Euro-Zone
members.

The EU is largely self-sufficient in food. As in the US, this is based, in part, on subsidies, minimum price
schemes and trade restrictions which favour farmers.

The EU is a net energy importer, although mutually beneficial strategic agreements with Russia and other
contiguous energy rich countries can provide security of supply. Significant potential natural gas finds in
the Eastern Mediterranean Sea may emerge as a source of energy for Europe.

The need for greater integration to deal with its debt problems may be the catalyst for the shift to
autarky.

As a single unit, the Euro-Zone’s current account is nearly balanced, its trade account has a small surplus,
the overall fiscal deficit is modest and the aggregate level of public debt while high is manageable. But
there are significant disparities between individual members of the Euro-Zone in terms of income levels,
public finances, external account and debt levels. Greater integration would help resolve some of these
variations.

However, it would necessitate a net wealth transfer from richer nations to weaker members. Stronger
more creditworthy members would also have to underwrite the borrowings of weaker
nations. Currently, there is significant opposition to such joint and several liabilities, predictably from net
lenders such as Germany, Finland and Netherlands.

But even without agreement on Euro-Zone bonds, de facto mutualisation of debt will take place. As more
financing for weaker nations moves to official institutions like the European Central Bank and bailout
funds, the commitment of stronger countries, especially Germany and France, increases. They implicitly
assume the liabilities of weaker members of the Euro-Zone.

If it fragments, then the Euro-Zone will morph into a smaller version of the original, probably consisting
of stronger core nations and a number of smaller entities. Nursing large losses and a significant
diminution of wealth, survivors are likely to favour autarkical policies to restore economic health.

Irrespective of its policy choices, Europe faces a prolonged period of economic stagnation as it works off
its debt burden and undertakes major structural changes to correct imbalances. During this transition,
Europe will be forced to focus internally, husbanding savings and wealth needed to absorb the required
large debt write-offs. Explicit or implicit capital controls and trade restrictions are natural policy measures
to assist in this adjustment, marking a shift to a more closed economy.

Chinese Historicism

The Chinese mercantilist model is also increasingly problematic, as growth slows and its weaknesses
emerge. China’s economy is largely closed, making it easier to adjust to the new environment.

China’s policy position is driven by the economic problems of its major trading partners. Given their lower
levels of growth, exports to Europe and America can no longer drive Chinese growth. China will have to
rely on domestic developments to drive the strong growth necessary to preserve social stability and the
rule of the Communist party. An internal focus would assist China to undertake the rebalancing of its
economy from one driven by exports and state directed debt financed investment to one with higher
consumption.

China’s economic redirection may be driven by its enormous loss of wealth, from engagement with the
West.

Before the financial crisis, the US purchased real goods and services from China, financing them with US
dollar denominated I-O-Us with low rates of interest. China’s $3.2 trillion in foreign exchange reserves are
invested, primarily in government bonds and other high quality securities denominated in US dollars,
Euro and Yen.

These investments have lost value, through increasing default risk (as the issuer’s ratings are
downgraded) and deliberate policies to engineer falls in the value of the foreign currency against the
Rimini. Attempts by the Chinese to liquidate reserve assets would result in sharp falls in the value of the
securities and a rise in the Rimini against the relevant currencies with large losses.

China has become increasingly concerned about the safety and security of Chinese savings. Chinese
resentment at the destruction of the value of its savings is increasing.

In an opinion piece published on 7 June 2012 in Financial Times, Jin Liwung, Chairman of the supervisory
board at the China Investment Corporation, the nation’s sovereign wealth fund, writing withKey
Jin, assistant professor at the London School of Economics, responded to criticism of China’s response to
the European debt crisis as follows: “From the outset of the crisis China has responded positively and
firmly to Europe’s appeal for support. But it should be received as an important and responsible
stakeholder, not as an outside creditor relegated to lower levels of seniority in moments of urgency. It
should be treated equally with the European Central Bank in the event of any debt restructuring.”

Reducing international engagement would allow China to write down its investment over time. This
would also minimise the need for further investment to protect the value of existing holdings, freeing up
resources for internal requirements.

As in any divorce, both partners – China and its major trading partners- increasingly recognise the lack of
mutual benefit in continuing existing arrangements.

At the July 2012 G-20 meeting in Mexico, China made it clear that it would not initiate the type and scale
of bank lending blitz that it did after the initial phase of the crisis to boost Chinese and global growth.
With China unwilling to take steps to become the consumer of last resort or open its markets to foreign
businesses, developed countries are increasing critical of Chinese policies.

China sees diminishing gains for engagement with external parties other than on its own terms. It resents
external pressures on its economic policies, currency value, trading practices, political system, foreign
policy and human rights record. China resents the hypocrisy of developed nations in dealing with a great
power.

Chinese history is shaped by successive humiliations in dealings with the West. Economic disengagement
is dictated, in part, by developing breakdowns in the relationship between China and its trading partners.

China’s has shifted its priority to food and energy security to sustain its development. China is purchasing
food and energy independence, through targeted investment in foreign suppliers. In some cases, these
investments also secure external markets for Chinese goods and services.

For China, a reversal of a policy represents a return to traditional economic self-reliance and a limited
interest in trade. As Robert Hart, 19th Century British trade commissioner for China, wrote: “[The]
Chinese have the best food in the world, rice; the best drink, tea; and the best clothing, cotton, silk, fur.
Possessing these staples and their innumerable native adjuncts, they do not need to buy a penny’s worth
elsewhere”. Engagement with gweilos (a Cantonese term meaning foreigners or foreign devils) is the
exception not the norm in Chinese history.

Fringe Dwellers

For nations without a large domestic economic, adequate economic resources or need for export
markets retreat from global integration poses challenges.
For example, smaller nations cannot influence exchange rates to the same exchange as the major
powers. Instead, countries require pragmatic strategies to prosper.

Alternative trading blocs to counter the shift to closed economies may evolve.

Natural resource rich countries may ally themselves with major nations, such as the US, Europe or China,
becoming preferred suppliers of food, energy or raw materials. In turn, they can reciprocate by becoming
markets for products or services and investment of their trading partners.

African countries are pursuing this policy, concluding long term supply agreements for agricultural or
mineral products sought by China. In return, China is expanding investment, trade and development aid
preferentially with these nations, co-ordinating transactions by Chinese businesses and banks.

Australia has emerged as an important source of raw materials for China. Russia has become an energy
and commodity supplier to Europe. Within the framework of NAFTA, Canada has become an important
energy supplier to the US while Mexico provides low cost labour to American businesses.

Strategically located, smaller trading oriented nations like Switzerland or Singapore can become
important trading or financial centres, providing trading, logistics, financial or investment services.

If they could overcome historical animosities and territorial conflicts, then Japan and China could evolve a
mutually beneficial strategic partnership. Japan is China’s second largest trading partner. Japan is also
one of its largest foreign investors.

Japan possesses advanced technology and needs markets for its exports. China is a large potential market
and Chinese businesses would benefit from Japanese skills and intellectual property. Still the world’s
largest pool of savings, Japan is continually seeking investment opportunities.

Despite a history of intermittent political differences, India may seek closer ties with China. Such an
alliance would help India overcome constraints including financing large current account and budget
deficits, investment capital requirements and infrastructure shortages. China would improve access to
raw materials and India’s large domestic market. Chindia is not far-fetched given the two countries have
rich cultural links reaching back to ancient times and increasing trade links.

Nations will have to abandon historical ties and biases, trading off political status against economic
prosperity and security in the new world order. In the British TV series Downtown Abbey, Cora Crawley
asks her mother-in-law: “Are we friends, then?” The Dowager Countess’ reply is instructive: “We are
allies, my dear, which can be a good deal more effective.” Smaller nations, unable to retreat into autarky,
will need to adjust strategies to make the most of the new world order.

Redrawing Battle Lines

The global financial crisis represents a historical discontinuity, driving significant changes in economic and
financial systems as well broader political structures.

Policy makers want to believe that the problems will be resolved and the world will revert to the status
quo. The depth of the problems and absence of easy cures means that major changes are likely. A
confluence of economic self-interest and necessity may drive a reversal of global integration, favouring
closed economies with more narrowly based strategic linkages between nations. This shift has important
implications.

Greater integration, free trade and free capital movements promoted growth. Now, lower economic
growth is reversing the trend, removing a key driver of growth. Lower growth in turn entrenches the
problems of unsustainable debt levels leading to a prolonged period of stagnation further reinforcing a
shift to autarky.

A world of closed economies alters the nature of trading arrangements, favouring bilateral agreements or
small trading blocs rather than global trade deals. The roles of international institutions such as the
World Bank, IMF, WTO and development institutions will need to change if they are to remain relevant.

Political alliances will be reshaped to reflect altered economic relationships. Security arrangements will
need to reflect new concerns, including guaranteeing the security of supply and transport of food, energy
and essential commodities.

The risk of armed conflict over resources has increased. Recent disputes over potential energy sources in
the South China and Yellow Seas highlight this risk. Disputes over water supplies in Asia have also
emerged.

The rise of autarky and corresponding nationalism is a dangerous cocktail. Stewart Patrick from the US
Council of Foreign Relations recently likened conditions in East Asia to Europe just before the First World
War. In the lead-up to the First Word War, Sir Norman Angel famously argued that the complex trade and
investment relationships between great European powers made armed conflict unthinkable.

But the possibility of a historical shift does not inform the current thinking of governments, central
bankers, financial institutions and businesses. The denial reflects what George Orwell identified as a
“major mental disease” afflicting intellectuals: “the instinct to bow down before the conqueror of the
moment, to accept the existing trend as irreversible”. A retreat to autarky and pursuance of policies that
favour closed economies is now a serious possibility with far reaching consequences that need to be
considered.

© 2013 Satyajit Das